Managing Office Lease Credit Risk With Free Rent Timing
The Problem
When structuring commercial real estate office leases, we have several tools at our disposal to manage credit risk: rate, free rent, deposits, guarantees, spend on buildouts, the language of the contract, etc. Of the options available to landlords in lease negotiations, free rent seems to take the back seat within the context of credit risk.
There's a market expectation of free rent quantity relative to duration. Beyond that, free rent becomes something landlords push around to manage investment objects as opposed to credit risk. And generally, the concern is quantity and not timing. For example, the landlord may have a face rent objective and offer greater free rent in exchange for a higher rate.
In my experiences with free rent, pressures from equity are capable of influencing decisions. When explaining drags on revenue during investor calls, ripping the band aid off tends to be a good strategy. I would much rather justify a large hit over a shorter period than a hit to revenue smaller in magnitude but persisting over a longer period. While experienced equity can be understanding, I've found myself losing support rather quickly when explaining the same issues again and again even when the issue is well within the expectations I originally set. So, I tend to front-load costs. Get the negatives out of the way and move on to better things. That said, I'm beginning to like my approach less and less.
Credit loss has never been material to my performance. Vacancy has consistently been greater in magnitude and frequency. I expect this is a common theme among operators. And dollar for dollar, I'll take vacancy over credit loss any day. Vacancy loss is (to a degree) exogenous. Whereas with credit loss, a decision was made that ultimately didn't work out and you're going to have to justify why. You'll say the loss was due to ''unforeseen circumstances,' but it's your signature on the lease.
When credit loss occurs, it tends to sting. You made a bet, you trusted a party, and they let you down. Whether it's a workout, deferment, termination, or default and recovery, the encounter tends to be adversarial and the probability of being made whole are low. Then comes the math. You evaluate unamortized leasing commissions, unamortized buildout costs, etc. When there's more duration ahead than behind, these costs add to the sting. You're likely underwater on the outlay
The cost that stings the most, in my opinion, is free rent. The value add of the buildouts is retained in the project; you'll tell yourself. If the buildouts aren't specific to a tenant's unique use, maybe there still is residual value. And the leasing commissions unamortized can be negotiated as discounts on future deals if your leasing team is willing to participate in the responsibility and they're still a part of the team following your loss. Free rent, on the other hand, is money out the door and gone forever. Worse, it's a transfer of value to the offending party.
But is free rent really gone in incidence of credit loss? In my opinion, probably. Any lease worth its salt will provide for recapture of abatement following a default event. However, if the tenant is in payment default, that's an object demonstration that the sum of remaining future payments is financially not feasible for the tenant. If recovery against future basic rental is unlikely, recapture of free rent is even less likely.
The Solution
Buildout costs must be amortized. Fundamentally, a buildout occurs before commencement and the outlay is the landlord's risk to carry. Leasing commissions tend to be settled following commencement. I've seen commission agreements where a portion of the commission are postponed and then canceled in case of default. However, I see far more agreements that front load commissions.
Free rent on the other hand, can occur whenever you'd like. You're effectively able to amortize this negotiated cost over the life of the lease by evenly distributing free rent over the lease's duration. There will be complaint. I expect prospective tenants to protest. But the concession is built in. Free rent offered in future periods will be at a higher rate assuming your rent schedule isn't flat. You're adjusting the concession for the time-value of money implicitly. Of course, this adds to landlord cost also. But think the tradeoff is justified. Furthermore, if your tenant digs in, I would be suspicious of their credit quality.
Other Considerations
Other things to keep in mind: credit quality signaling, settlement statement implications, and CAM reconciliation payments.
Credit Signaling
A prospective tenant's willingness to agree to moving around the timing of abatement payments may have informative value. As mentioned earlier, abatement offered in future periods will (likely) be at the higher rate. If the higher rate is sufficient to compensate for the opportunity cost associated with the time value of money, the tenant should be indifferent between greater abatement tomorrow and lesser abatement today.
Partiality to front-loaded free rent may indicate poor credit quality. Insisting on this structure may indicate an inability to afford rent. Perhaps the tenant intends to grow into their rent. Tenant reps have a perverse incentive to sell the vision on more versus less space to boost the commission value. Once a party is emotionally anchored to a space, they'll rationalize why it's a good decision, overestimate their growth, etc. Spreading out free rent and beginning collections earlier forces the tenant to demonstrate their ability to perform under the lease. Of course, this isn't a substitute for formal credit analysis. You still need thoroughly screen your tenants.
Settlement Statement
Another factor within the context of investment objectives that can bias operators is the settlement statement. I don't like adding seller credits for abatement relating to existing leases. The reason is that you're reducing the capital available for re-investment. When approaching an anticipated sale, I want to front load free rent to burn it off through the income statement, so it's not represented on the settlement statement.
Doing so allows us to capture the tax benefit in the current period. While adding a credit to the settlement statement will reduce your gain, our (hopefully) gain will be likely deferred and possible deferred indefinitely. Exchanging property and deferring gain is what makes real estate a tax efficient investment and contributes significantly to investment performance. Thus, assuming the exchange will occur is prudent.
Start out by distributing abatement evenly. Then as you approach a planned sale, start concentrating free rent earlier in the lease's life. Plus, you're not going to be around to live out the tenant's credit anyways. This might sound contrarian to the original position, but managing competing objectives is a part of our job.
On the other hand, if I know I'm exiting cash, or I'm in a loss position without a deferred gain floating around, I may be less motivated to front-load. A deal isn't done until the cash is in your account (or your accommodator’s account).
CAM Reconciliations
Many office leases allow for expense reimbursement for increases in expenses beyond a base year. This is an important component to managing uncertainty of future expenses. But one thing's for certain, tenants don't like CAMs. Tenants don't like impounds and they don't like reconciliation payments.
Now consider if the reconciliation payment was made against an invoice with basic rental abated. There may be less objection or attention paid to your CAM statement. Often, CAMs are reconciled against the calendar year. If you're confident that operations will have your CAM process complete in February, drop your free rent in March so CAMs appear along a heavily reduced or vacant invoice.
Final Thoughts
I've demonstrated above a handful of items to consider when structuring the timing of free rent. As I mentioned earlier, these aren't best practices I've trusted for years. I previously preferred to see free rent front loaded. However, I'm beginning to change my mind. Going forwards, I intend to distribute free rent evenly throughout the life of the lease. As I approach a potential sale, I might begin to bias abatement forwards once again. But this will be contingent on an exchange as well as not being in a loss position.